How much your employees need to save for their retirement: rules of thumb

There, in black and white

NB Bulletin Vol. 12 N. 9, July 2009

The current financial market crisis has led many employees to question some fundamental retirement savings concepts and strategies. Will investment in stocks yield a better long-term return than an investment in bonds? Add to this the fact that, beyond contributions paid to your capital accumulation plan (CAP), whether it is a defined contribution (DC) registered pension plan, a group registered retirement savings plan (RRSP) or a deferred profit-sharing plan (DPSP), your employees generally find it difficult to determine how much they need to save for retirement.

During such turbulent times, we must be careful not to throw out the baby with the bath water. If you offer your employees a CAP and you want to answer some of their questions, follow the rules of thumb below that will make their retirement planning easier.

Retirement planning requires making three key investment decisions (in order of importance): 1) How much do I need to save? 2) In which asset categories should I invest? (including allocation among them) and 3) Which funds/managers should I use? Although fund/manager selection is the third most important decision, the media and specialized investment advisors give special weight to this decision. Several studies have shown that Canadians do not save enough for retirement and that around 85% of the return obtained on retirement savings is attributable to allocation among asset categories whereas the balance (15%) is attributable to choice of funds/managers.

How much do I need to save?

The ideal way to determine how much to save is to have employees plan their retirement activities, estimate the income needed to complete these activities and then establish (project) the retirement savings level required to achieve this goal. Recommend that your employees contact your CAP administrator's call centre, which offers various tools that will help them with this exercise. They are also free to contact the financial planner of their choice. You can also suggest that they follow the rules of thumb below:

The retirement savings level will depend on a number of assumptions. The main assumptions for these rules of thumb are as follows:

Annual retirement income equal to 70% of pre-retirement salary (including government plans)

Started saving at age 27

Retirement at age 65

3.5% return above inflation each year

Coverage of half of inflation throughout retirement

The retirement savings level also includes the amounts paid to any other RRSP or to a locked-in retirement account (LIRA), and the value of any annuity paid from a defined benefit (DB) registered pension plan in which the employee previously participated or payable directly from a life insurance company.

The second rule of thumb is better illustrated through an example. If your employee currently earns an annual salary of $50 000 and is 48 years of age, he/she should have accumulated twice (48 divided by 6 minus 6) his/her salary (or $100 000) among all his/her retirement savings vehicles. These assets accumulated to date, added to future contributions, returns on these amounts and government plans (Quebec Pension Plan and Old Age Security benefit), should be sufficient to provide an annual retirement income equal to 70% of the employee's salary at retirement. This rule of thumb is, however, a minimum. For instance, under this rule of thumb, sizeable salary increases will require a significant increase in future contributions. Moreover, if your employee is considering retiring before age 65 or if his/her returns were lower than expected, he/she must save additional amounts.

In which asset categories should I invest?

To answer this question, employees must first determine their investor profile. Your CAP administrator, as well as many financial advisors and institutions, have access to various tools used to determine this profile. You can, however, suggest that your employees use the following rules of thumb to determine the percentage to invest in stocks:

Aggressive profile: 120 minus age

Moderate profile: 100 minus age

Conservative profile: 80 minus age

Thus, for an employee aged 48 with a moderate profile, the rule of thumb recommends investing 52% (100 minus 48) of the retirement savings in stocks. You will notice that with this rule of thumb the percentage will decrease as the employee approaches retirement, thereby decreasing the risk of these savings fluctuating significantly during the period preceding retirement. Many investors experienced this type of fluctuation in 2008. It is important for your employees to ensure that they do not let their age influence their choice of investor profile because this will introduce an unnecessary conservative bias. When your employees approach retirement (for example in the three years before retirement), you can recommend that they review their asset allocation based on their retirement payments strategy.

Lifecycle funds, introduced in the United States in the early 2000s and a few years later in Canada, gradually replaced balanced funds as a simplified retirement savings solution. These solutions now better support savers up to retirement and use asset allocation strategies that change in the same manner as the rules of thumb presented above.

What funds/managers should I use?

There is currently no rule of thumb that can be used to answer this third question. However, when selecting the appropriate funds/managers for your employees, keep in mind that they will not be investing in the past, but in the future. Be sure to ask the right questions to assess return forecasts for the funds/managers being considered, and do not rely solely on past returns.

Finally, although rules of thumb are useful when it comes to retirement planning, they are not considered advice and do not replace planning tailored for each employee.